- After peaking in early 2018, the euro has weakened against the US dollar
- Going forward, slowing growth and inflation continue to weigh on the euro
- Relative to recent history, speculator positioning can also fall much further
In our last take on the euro in April, we wrote that the bullish case for the currency was running out of drivers. Specifically, we wrote that decelerating Eurozone growth (in rate-of-change terms), changes in trading patterns and overly bullish speculator sentiment was likely to weigh on the euro in the future. At the time, EUR/USD was trading around 1.23, near its 2018 high just above 1.2550.
As a ‘risk on’ currency, the euro tends to weaken when Eurozone growth is decelerating in rate-of-change terms. Looking at the data, Eurozone growth peaked in late 2017. However, the euro did not start weakening until the second quarter of this year. While changes in growth and inflation drive currencies at a macro level, traders still need to respect day-to-day trading patterns in order to maximize their profits. As a research service focused on currencies and commodities, we pay close attention to both economic data as well as quantitative trading patterns such as trading volumes and volatility.
So far, our non-consensus view has been proven correct as the euro has sold off sharply since April. Going forward, we expect the euro to continue selling off thanks to (1) slowing growth, (2) slowing inflation and (3) outsized speculator positioning relative to recent history. As a trading recommendation, we recommend shorting EUR/USD towards the upper end of its daily trading range (updated daily).
Falling sentiment + steepening base effects = slowing growth
Since late 2016, year-over-year Eurozone growth has been rising in rate-of-change terms. While many claim that the euro strengthened last year because of Macron’s victory in the French presidential elections, the reality is that the currency was also helped along by improving economic data. In particular, forward-looking indicators (such as manufacturing sentiment) rose sharply while year-over-year growth figures were helped by weak comparables. That is, relatively weak growth in 2015 and 2016 (the denominator) helped Eurozone growth accelerate to 2%+ without any hiccups. This is highlighted below:
A changing picture
As can be seen above, manufacturing sentiment (a reliable front-runner for Eurozone growth) peaked in early 2018. As a result, one of the key drivers for future growth is weakening. Beyond forward-looking indicators, Eurozone growth will also have to wrestle with steepening base effects going into the second half of this year (indicated in red above). Between Q1 2017 and Q4 2017, Eurozone growth accelerated from 2.2% to 2.7%. As the denominator will keep rising, future rates of growth will increasingly come under pressure.
This can already be seen in the data. The most recent figure for year-over-year growth (Q2 2018) has slowed to 2.2% from 2.7% in Q4 2018.
Rising interest rates when inflation is slowing? Unlikely
While the ongoing growth slowdown is relatively clear, some euro bulls will point to accelerating inflation as a positive factor. Over the past few months, headline inflation across the Eurozone has accelerated to 2%+ in response to rising commodity prices. As the ECB is officially on a tightening path, some argue that rising rate hike expectations will help the euro. This is illustrated below:
Running out of steam
As can be seen above, changes in commodity prices (in this case, Brent crude oil prices) are a reliable front-runner for changes in headline inflation. Eurozone inflation spiked in early 2017 in response to rising crude oil prices. More recently, Eurozone inflation is once again accelerating thanks to rising crude oil prices. The impact from higher commodity prices (which are priced in dollars) is especially pronounced this year following the euro’s sell-off against the US dollar.
Going forward, we expect inflation to begin slowing using the same logic we used to determine the outlook for Eurozone growth. Specifically, (1) crude oil prices are now slowing in rate-of-change terms and (2) steepening base effects will weigh on upcoming inflation figures.
After peaking just above $80/barrel in May, Brent crude has been unable to keep strengthening. As a result, rising commodity prices will become a weaker driver for inflation going forward. Beyond commodity prices, base effects are also set to weigh on upcoming inflation figures. At this time last year, Eurozone CPI accelerated from 1.3% in July 2017 to 1.5% in September 2017. As a result of both peaking growth in crude oil prices and a rising denominator, we expect Eurozone inflation to begin slowing over the coming months.
Watch out below, as speculator positions can fall much lower
Beyond slowing growth and inflation, speculator positioning in the euro is an additional risk factor. Two weeks ago, foreign exchange speculators went net short the euro for the first time since May 2017. At first glance, this may suggest that the ‘short euro’ trade has already played out. After all, if consensus positioning (which tends to lag price action) is already net short, can the euro really fall further? To answer this question, it is helpful to look at historical net positions in the euro, which is shown below:
Look at the bigger picture
As can be seen above, speculator positions (in euro options and futures contracts) have fallen to more than 200,000 contracts net short in recent history. Recent lows in speculator positioning are indicated in red in the chart above. In fact, speculator positioning in the euro has been net short more often than net long over the past few years. While many analysts are pointing to the dramatic change in positioning over the past few months, few are looking at the ‘bigger picture’.
As the outlook for Eurozone growth deteriorates, positioning in the euro can fall much further. Historically, speculators have maintained big net short positions following episodes of slowing Eurozone growth. This time is unlikely to be different.
Shorting the euro remains an enticing opportunity
As the euro undergoes a rebound (with EUR/USD rising towards 1.17 as of August 27), shorting the currency is becoming more and more attractive. In the short-term, Fed Chair Powell’s comments on inflation and China’s moves to support the yuan are suppressing the US dollar (in turn, helping the euro).
Over the longer term, the euro won’t be able to escape a global downturn that is just getting started. Beyond weakness in domestic economic data, the euro is particularly vulnerable to a more significant sell-off thanks to a growing nonperforming loan problem (particularly in periphery countries such as Italy and Portugal), as well as an aging population. While foreign exchange traders happily ignored the region’s poor fundamentals during last year’s bull market, they are unlikely to be as forgiving during a global downturn.